Microeconomics of Banking

Second Edition1

Xavier Freixas and Jean-Charles Rochet 21st December 2006

1 This

second edition is dedicated to the memory of Jean-Jacques Laont.

Contents

1 General Introduction 1.1 1.2 What Is a Bank, and What Do Banks Do? . . . . . . . . . . . . . . . . . . Liquidity and Payment Services . . . . . . . . . . . . . . . . . . . . . . . . 1.2.1 1.2.2 1.3 1.4 Money Changing . . . . . . . . . . . . . . . . . . . . . . . . . . . . Payment Services . . . . . . . . . . . . . . . . . . . . . . . . . . . .

19 19 21 21 22 23 24 24 24 25 26 26 27 28 28 28 29 30 35 38

Transforming assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Managing Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4.1 1.4.2 1.4.3 Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest Rate and Liquidity Risks . . . . . . . . . . . . . . . . . . . O-Balance-Sheet Operations . . . . . . . . . . . . . . . . . . . . .

1.5 1.6 1.7

Monitoring and Information Processing . . . . . . . . . . . . . . . . . . . . The Role of Banks in the Resource Allocation Process . . . . . . . . . . . . Banking in the Arrow-Debreu Model . . . . . . . . . . . . . . . . . . . . . 1.7.1 1.7.2 1.7.3 1.7.4 The Consumer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . General Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . .

1.8

Outline of the Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2 The Role of Financial Intermediaries 2.1 Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTENTS

2.1.1 2.1.2 2.2

Economies of Scope . . . . . . . . . . . . . . . . . . . . . . . . . . . Economies of Scale . . . . . . . . . . . . . . . . . . . . . . . . . . .

39 40 41 41 42 42 43 44 45 46 48 49 50 51 55 55 57

Coalitions of Depositors and Liquidity Insurance . . . . . . . . . . . . . . . 2.2.1 2.2.2 2.2.3 2.2.4 2.2.5 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Characteristics of the Optimal Allocation . . . . . . . . . . . . . . . Autarky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market Economy . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financial Intermediation . . . . . . . . . . . . . . . . . . . . . . . .

2.3

Coalitions of Borrowers and the Cost of Capital . . . . . . . . . . . . . . . 2.3.1 2.3.2 2.3.3 2.3.4 A Simple Model of Capital Markets with Adverse Selection . . . . . Signaling Through Self-Financing and the Cost of Capital . . . . . Coalitions of Borrowers . . . . . . . . . . . . . . . . . . . . . . . . . Suggestions for further Reading . . . . . . . . . . . . . . . . . . . .

2.4 2.5

Financial Intermediation as Delegated Monitoring . . . . . . . . . . . . . . The Choice Between Market Debt and Bank Debt . . . . . . . . . . . . . . 2.5.1 2.5.2 2.5.3 2.5.4 2.5.5 A Simple Model of the Credit Market with Moral Hazard . . . . . . Monitoring and Reputation (Adapted from Diamond 1991) . . . . .

Monitoring and Capital (Adapted from Holmstr om and Tirole 1997) 59 Financial Architecture (Boot and Thakor 1997) . . . . . . . . . . . Credit Risk and Dilution Costs (Bolton Freixas 2000) . . . . . . . . 62 63 67 68 69 69 70 71 71

2.6 2.7 2.8

Liquidity Provision to Firms . . . . . . . . . . . . . . . . . . . . . . . . . . Suggestions for further reading . . . . . . . . . . . . . . . . . . . . . . . . . Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.8.1 2.8.2 Strategic Entrepreneurs and Market Financing . . . . . . . . . . . . Market vs. Bank Finance . . . . . . . . . . . . . . . . . . . . . . .

2.9

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.9.1 Strategic Entrepreneurs and Market Financing . . . . . . . . . . . .

CONTENTS

2.9.2 2.9.3 2.9.4 2.9.5 2.9.6

Market vs. Bank Finance . . . . . . . . . . . . . . . . . . . . . . . Economies of Scale in Information Production . . . . . . . . . . . . Monitoring as a Public Good and Greshams Law . . . . . . . . . . Intermediation and Search Costs (Adapted from Gehrig 1993) . . . Intertemporal Insurance . . . . . . . . . . . . . . . . . . . . . . . .

72 75 75 77 77 79 79 79 81 82 89 90 90 92 93 94 97 97 98 99

2.10 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.10.1 Economies of Scale in Information Production . . . . . . . . . . . . 2.10.2 Monitoring as a Public Good and Greshams Law . . . . . . . . . . 2.10.3 Intermediation and Search Costs . . . . . . . . . . . . . . . . . . . 2.10.4 Intertemporal Insurance . . . . . . . . . . . . . . . . . . . . . . . . 3 The Industrial Organization Approach to Banking 3.1 A Model of a Perfect Competitive Banking Sector . . . . . . . . . . . . . . 3.1.1 3.1.2 3.1.3 3.1.4 3.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Credit Multiplier Approach . . . . . . . . . . . . . . . . . . . . The Behavior of Individual Banks in a Competitive Banking Sector The Competitive Equilibrium of the Banking Sector . . . . . . . . .

The Monti-Klein Model of a Monopolistic Bank . . . . . . . . . . . . . . . 3.2.1 3.2.2 3.2.3 The Original Model . . . . . . . . . . . . . . . . . . . . . . . . . . . The Oligopolistic Version . . . . . . . . . . . . . . . . . . . . . . . . Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . .

3.3

Monopolistic Competition . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 3.3.1 3.3.2 3.3.3 3.3.4 Does Free Competition Lead to the Optimal Number of Banks? . . 101 The Impact of Deposit Rate Regulation on Credit Rates . . . . . . 103 Bank Network Compatibility . . . . . . . . . . . . . . . . . . . . . . 106 Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 107

3.4 3.5

The Scope of the Banking Firm . . . . . . . . . . . . . . . . . . . . . . . . 107 Beyond price competition . . . . . . . . . . . . . . . . . . . . . . . . . . . 108

CONTENTS

3.5.1 3.5.2 3.5.3 3.6

Risk taking on investments . . . . . . . . . . . . . . . . . . . . . . . 109 Monitoring and incentives in a nancial conglomerate . . . . . . . . 113 Competition and screening . . . . . . . . . . . . . . . . . . . . . . . 115

Relationship Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119 3.6.1 3.6.2 3.6.3 3.6.4 3.6.5 The Ex Post Monopoly of Information . . . . . . . . . . . . . . . . 120 Equilibrium with Screening and Relationship Banking . . . . . . . . 122 Does Competition Threaten Relationship Banking? . . . . . . . . . 123 Intertemporal Insurance . . . . . . . . . . . . . . . . . . . . . . . . 124 Empirical Tests of Relationship Banking . . . . . . . . . . . . . . . 125

3.7

Payment Cards and Two-Sided Markets . . . . . . . . . . . . . . . . . . . 128 3.7.1 3.7.2 3.7.3 3.7.4 3.7.5 A Model of the Payment Card Industry . . . . . . . . . . . . . . . . 129 Cards Usage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130 Monopoly Network . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 Competing Payment Card Networks . . . . . . . . . . . . . . . . . 131

Welfare Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132

3.8

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 3.8.1 Extension of the Monti-Klein Model to the Case of Risky Loans (Adapted from Dermine 1986) . . . . . . . . . . . . . . . . . . . . . 133 Compatibility between Banking Networks (Adapted from Matutes and Padilla 1994) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 Double Bertrand Competition . . . . . . . . . . . . . . . . . . . . . 134 Deposit Rate Regulation . . . . . . . . . . . . . . . . . . . . . . . . 135

3.8.2

3.8.3 3.8.4 3.9

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135 3.9.1 3.9.2 3.9.3 3.9.4 Extension of the Monti-Klein Model to the Case of Risky Loans . . 135 Compatibility between Banking Networks . . . . . . . . . . . . . . 136 Double Bertrand Competition . . . . . . . . . . . . . . . . . . . . . 138 Deposit Rate Regulation . . . . . . . . . . . . . . . . . . . . . . . . 138

CONTENTS

4 The LenderBorrower Relationship 4.1 4.2

149

Why Risk Sharing Does Not Explain All the Features of Bank Loans . . . 150 Costly State Verication . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152 4.2.1 4.2.2 4.2.3 Incentive Compatible Contracts . . . . . . . . . . . . . . . . . . . . 153 Ecient Incentive Compatible Contracts . . . . . . . . . . . . . . . 154 Ecient Falsication-Proof Contracts . . . . . . . . . . . . . . . . . 155

4.3

Incentives to Repay . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157 4.3.1 4.3.2 4.3.3 4.3.4 Nonpecuniary cost of bankruptcy . . . . . . . . . . . . . . . . . . . 157 Threat of Termination . . . . . . . . . . . . . . . . . . . . . . . . . 158 Impact of Judicial Enforcement . . . . . . . . . . . . . . . . . . . . 159 Strategic Debt Repayment: The Case of a Sovereign Debtor . . . . 161

4.4 4.5

Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165 The Incomplete Contract Approach . . . . . . . . . . . . . . . . . . . . . . 168 4.5.1 4.5.2 4.5.3 Private Debtors and the Inalienability of Human Capital . . . . . . 169 Liquidity of Assets and Debt Capacity . . . . . . . . . . . . . . . . 171 Soft Budget Constraints and Financial Structure . . . . . . . . . . . 173

4.6 4.7

Collateral as a Device for Screening Heterogenous Borrowers . . . . . . . . 176 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179 4.7.1 4.7.2 Optimal Risk Sharing with Symmetric Information . . . . . . . . . 179 Optimal Debt Contracts with Moral Hazard (Adapted from Innes 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180 The Optimality of Stochastic Auditing Schemes . . . . . . . . . . . 181 The Role of Hard Claims in Constraining Management (Adapted from Hart and Moore 1995) . . . . . . . . . . . . . . . . . . . . . . 182 Collateral and Rationing (Adapted from Besanko and Thakor 1987) 182 Securitization (Adapted from Greenbaum and Thakor 1987) . . . . 183

4.7.3 4.7.4

4.7.5 4.7.6 4.8

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 184 4.8.1 Optimal Risk Sharing with Symmetric Information . . . . . . . . . 184

CONTENTS

4.8.2 4.8.3 4.8.4 4.8.5 4.8.6

Optimal Debt Contracts with Moral Hazard . . . . . . . . . . . . . 184 The Optimality of Stochastic Auditing Schemes . . . . . . . . . . . 185 The Role of Hard Claims in Constraining Management . . . . . . . 186 Collateral and Rationing . . . . . . . . . . . . . . . . . . . . . . . . 187 Securitization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 188 193

5 Equilibrium in the Credit Market... 5.1 5.2 5.3

Denition of Equilibrium Credit Rationing . . . . . . . . . . . . . . . . . . 194 The Backward Bending Supply of Credit . . . . . . . . . . . . . . . . . . . 195 Equilibrium Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . 197 5.3.1 5.3.2 5.3.3 Adverse Selection . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197 Costly State Verication . . . . . . . . . . . . . . . . . . . . . . . . 199 Moral Hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

5.4 5.5

Equilibrium with a Broader Class of Contracts . . . . . . . . . . . . . . . . 202 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206 5.5.1 5.5.2 5.5.3 The Model of Mankiw (1986) . . . . . . . . . . . . . . . . . . . . . 206 Ecient Credit Rationing (Adapted from De Meza and Webb 1992) 207 Too Much Investment (Adapted from De Meza and Webb 1987) . . 207

5.6

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208 5.6.1 5.6.2 5.6.3 The Model of Mankiw (1986) . . . . . . . . . . . . . . . . . . . . . 208 Ecient Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . 208 Too Much Investment . . . . . . . . . . . . . . . . . . . . . . . . . 209 215

6 The Macroeconomic Consequences of Financial... 6.1 6.2

A Short Historical Perspective . . . . . . . . . . . . . . . . . . . . . . . . . 217 The Transmission Channels of Monetary Policy . . . . . . . . . . . . . . . 218 6.2.1 6.2.2 The Dierent Channels . . . . . . . . . . . . . . . . . . . . . . . . . 220 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221

CONTENTS

6.2.3

Credit View versus Money View: Justication of the Assumptions and Empirical Evidence . . . . . . . . . . . . . . . . . . . . . . . . 223 Empirical Evidence on the Credit View . . . . . . . . . . . . . . . . 225

6.2.4 6.3 6.4

Financial Fragility and Economic Performance . . . . . . . . . . . . . . . . 226 Financial Development and Economic Growth . . . . . . . . . . . . . . . . 232 243

7 Individual Bank Runs and Systemic Risk 7.1

Banking Deposits and Liquidity Insurance . . . . . . . . . . . . . . . . . . 244 7.1.1 7.1.2 7.1.3 7.1.4 7.1.5 A Model of Liquidity Insurance . . . . . . . . . . . . . . . . . . . . 245 Autarky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 The Allocation... . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246 The Optimal (Symmetric) Allocation . . . . . . . . . . . . . . . . . 246 A Fractional Reserve Banking System . . . . . . . . . . . . . . . . . 247

7.2

The Stability of the Fractional Reserve System... . . . . . . . . . . . . . . . 248 7.2.1 7.2.2 7.2.3 7.2.4 The Causes of Instability . . . . . . . . . . . . . . . . . . . . . . . . 248 A First Remedy to Instability: Narrow Banking . . . . . . . . . . . 249 Regulatory Responses: Suspension... . . . . . . . . . . . . . . . . . 251 Jacklins Proposal: Equity versus Deposits . . . . . . . . . . . . . . 252

7.3 7.4 7.5

Bank Runs and Renegotiation . . . . . . . . . . . . . . . . . . . . . . . . . 254 Ecient Bank Runs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 258 Interbank Markets and the Management... . . . . . . . . . . . . . . . . . . 260 7.5.1 7.5.2 7.5.3 The Model of Bhattacharya and Gale (1987) . . . . . . . . . . . . . 261 The Role of the Interbank Market . . . . . . . . . . . . . . . . . . . 261 The Case of Unobservable Liquidity Shocks . . . . . . . . . . . . . 262

7.6

Systemic risk and contagion . . . . . . . . . . . . . . . . . . . . . . . . . . 263 7.6.1 7.6.2 7.6.3 Aggregate liquidity and banking crises . . . . . . . . . . . . . . . . 264 Payment systems and OTC operations . . . . . . . . . . . . . . . . 266 Contagion through interbank claims . . . . . . . . . . . . . . . . . . 267

10

CONTENTS

7.7

The Lender of Last Resort:... . . . . . . . . . . . . . . . . . . . . . . . . . . 270 7.7.1 7.7.2 7.7.3 7.7.4 Four Views on the LLR Role . . . . . . . . . . . . . . . . . . . . . . 271 Liquidity and solvency: a coordination game . . . . . . . . . . . . . 272 The practice of LLR assistance . . . . . . . . . . . . . . . . . . . . 275 The Eect of LLR and Other Partial Arrangements . . . . . . . . . 275

7.8

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277 7.8.1 7.8.2 7.8.3 7.8.4 7.8.5 7.8.6 Bank Runs and Moral Hazard . . . . . . . . . . . . . . . . . . . . . 277 Bank runs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278 Information-Based Bank Runs... . . . . . . . . . . . . . . . . . . . . 279 Banks Suspension of Convertibility... . . . . . . . . . . . . . . . . . 279 Aggregate Liquidity Shocks (adapted from Hellwig (1994)) . . . . . 281 Charter Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282

7.9

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282 7.9.1 7.9.2 7.9.3 7.9.4 7.9.5 7.9.6 Banks Runs and Moral Hazard . . . . . . . . . . . . . . . . . . . . 282 Bank runs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283 Information-Based Bank Runs . . . . . . . . . . . . . . . . . . . . . 284 Banks Suspension of Convertibility . . . . . . . . . . . . . . . . . . 284 Aggregated Liquidity Shocks . . . . . . . . . . . . . . . . . . . . . . 286 Charter Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 287 295

8 Managing Risks in the Banking Firm 8.1

Credit Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296 8.1.1 8.1.2 8.1.3 Institutional Context . . . . . . . . . . . . . . . . . . . . . . . . . . 296 Evaluating the Cost of Credit Risk . . . . . . . . . . . . . . . . . . 297 Regulatory Response to Credit Risk . . . . . . . . . . . . . . . . . . 302

8.2

Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304 8.2.1 8.2.2 Reserve Management . . . . . . . . . . . . . . . . . . . . . . . . . . 305 Introducing Liquidity Risk in the Monti-Klein Model . . . . . . . . 306

CONTENTS

11

8.2.3 8.3

The Bank as a Market Maker . . . . . . . . . . . . . . . . . . . . . 308

Interest Rate Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 311 8.3.1 8.3.2 8.3.3 The Term Structure of Interest Rates . . . . . . . . . . . . . . . . . 312 Measuring Interest Rate Risk Exposure . . . . . . . . . . . . . . . . 314 Applications to Asset Liability Management . . . . . . . . . . . . . 315

8.4

Market Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317 8.4.1 8.4.2 Portfolio Theory: The Capital Asset Pricing Model . . . . . . . . . 317 The Bank as a Portfolio Manager: The Pyle (1971), Hart-Jaee (1974) Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319 An Application of the Portfolio Model: The Impact of Capital Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

8.4.3

8.5

Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 327 8.5.1 8.5.2 8.5.3 The Model of Prisman, Slovin, and Sushka (1986) . . . . . . . . . . 327 The Risk Structure of Interest Rates (Adapted from Merton 1974) . 328 Using the CAPM for Loan Pricing . . . . . . . . . . . . . . . . . . 329

8.6

Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330 8.6.1 8.6.2 8.6.3 The Model of Prisman, Slovin, and Sushka . . . . . . . . . . . . . . 330 The Risk Structure of Interest Rates . . . . . . . . . . . . . . . . . 331 Using the CAPM for Loan Pricing . . . . . . . . . . . . . . . . . . 332 337

9 The Regulation of Banks 9.1

The Justication of Banking Regulations . . . . . . . . . . . . . . . . . . . 338 9.1.1 9.1.2 9.1.3 9.1.4 The General Setting . . . . . . . . . . . . . . . . . . . . . . . . . . 339 The Fragility of Banks . . . . . . . . . . . . . . . . . . . . . . . . . 340 The Protection of Depositors and Customers Condence . . . . . . 341 The Cost of Bank Failures . . . . . . . . . . . . . . . . . . . . . . . 343

9.2 9.3

A Framework for Regulatory Analysis . . . . . . . . . . . . . . . . . . . . . 344 Deposit Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

12

CONTENTS

9.3.1 9.3.2 9.3.3 9.3.4 9.4

The Moral Hazard Issue . . . . . . . . . . . . . . . . . . . . . . . . 347 Risk-Related Insurance Premiums . . . . . . . . . . . . . . . . . . . 348 Is Fairly Priced Deposit Insurance Possible? . . . . . . . . . . . . . 350 The Eects of Deposit Insurance on the Banking Industry . . . . . 351

Solvency Regulations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 9.4.1 9.4.2 9.4.3 9.4.4 9.4.5 The Portfolio Approach . . . . . . . . . . . . . . . . . . . . . . . . 353 Cost of Bank Capital and Deposit Rate Regulation . . . . . . . . . 354 The Incentive Approach . . . . . . . . . . . . . . . . . . . . . . . . 356 The Incomplete Contract Approach . . . . . . . . . . . . . . . . . . 358 The 3 Pillars of Basel 2 . . . . . . . . . . . . . . . . . . . . . . . . . 362

9.5

The Resolution of Bank Failures . . . . . . . . . . . . . . . . . . . . . . . . 362 9.5.1 9.5.2 9.5.3 Resolving Banks Distress: Instruments and Policies . . . . . . . . . 363 Information Revelation and Managers Incentives . . . . . . . . . . . 364 Who Should Decide on Banks Closure? . . . . . . . . . . . . . . . 366

9.6 9.7 9.8

Market Discipline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369 Further Readings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374 9.8.1 Moral hazard and capital regulation . . . . . . . . . . . . . . . . . . 374

9.9

SOLUTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 9.9.1 Moral hazard and capital regulation . . . . . . . . . . . . . . . . . . 375

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13

A la m emoire de Jean-Jacques Laont

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Preface
During the last three decades, the economic theory of banking has entered a process of change that has overturned economists traditional vision of the banking sector. Before that, banking courses of most doctoral programs in Economics, Business, or Finance focused either on management aspects (with a special emphasis on risk) or on monetary aspects and their macroeconomic consequences. Thirty years ago, there was no such thing as a Microeconomic Theory of Banking, for the simple reason that the Arrow-Debreu general equilibrium model (the standard reference for Microeconomics at that time) was unable to explain the role of banks in the economy.1 Since then, a new paradigm has emerged (the asymmetric information paradigm), centered around the assumption that dierent economic agents possess dierent pieces of information on relevant economic variables, and that agents will use this information for their own prot. This paradigm has proved extremely powerful in many areas of economic analysis. Regarding banking theory, it has been useful in both explaining the role of banks in the economy and pointing out the structural weaknesses of the banking sector (exposition to runs and panics, persistence of rationing on the credit market, recurrent solvency problems) that may justify public intervention. This book provides a guide to this new microeconomic theory of banking. Rather than seek exhaustivity, we have focused on the main issues, providing the necessary tools to understand how they have been modeled. We have selected contributions that we found to be both important and accessible to second-year doctoral students in Economics, Business, or Finance. What is new in the second edition. Since the publication of the rst edition of this book, the development of academic research on microeconomics of banking has been spectacular. This second edition attempts to cover most of the articles that we view as representative of these new developments. Three topics are worth mentioning. First, the analysis of competition between banks has been rened by paying more attention to non-price competition, namely competition through other strategic variables than interest rates (or service fees). For example banks compete on the level of asset risk they take or the intensity of the monitoring of borrowers. These dimensions are crucial to shed light on two critical issues: the competition-stability trade-o and the impact of entry of new banks, both issues of concern for prudential regulation. Second, the literature on the macroeconomic impact of the nancial structure of rms
1

This disappointing property of the Arrow-Debreu model is explained in Chapter 1.

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15

has made signicant progress on at least two questions: the transmission of monetary policy and the eect of capital requirements for banks on the functioning of the credit market. Finally, the theoretical foundations of banking regulation have been claried, even though the recent developments in risk modeling (due in particular to the new Basel accords on banks solvency regulation) have not yet led to a signicant parallel development of economic modeling.

Prerequisites
This book focuses on the theoretical aspects of banking. A preliminary knowledge of the institutional aspects of banking, taught for instance in undergraduate courses on Money and Banking, is therefore useful. Good references are the textbooks of Mishkin (1993) or Garber and Weisbrod (1992). An excellent transition between these textbooks and the theoretical material developed here can be found in Greenbaum and Thakor (1995). A good knowledge of microeconomic theory (at the level of a rst-year graduate course) is also needed: decision theory, general equilibrium theory and its extensions to uncertainty (complete contingent markets) and dynamic contexts, game theory, incentives theory. An excellent reference that covers substantially more material than is needed here is Mas Colell, Whinston, and Green (1995). More specialized knowledge on contract theory (Salani e 1996, Laont and Martimort 2002, Bolton and Dewatripont 2006) or game theory (Fudenberg and Tirole 1991, Gibbons 1992, Kreps 1990, or Myerson 1991) is not needed but can be useful. Similarly, a good knowledge of the basic concepts of modern nance (Capital Asset Pricing Model [CAPM], Option Pricing) is recommended (see, for instance, Huang and Litzenberger 1988 or Ingersoll 1987). An excellent complement to this book is the corporate nance treatise of Tirole (2006). Finally, the mathematical tools needed in this book are to be found in undergraduate courses in dierential calculus and probability theory. Some knowledge of diusion processes (in connection with Black-Scholess option pricing formula) is also useful.

Acknowledgments
Our main debt is the intellectual inuence of the principal contributors to the Microeconomic Theory of Banking, especially Benjamin Bernanke, Patrick Bolton, Doug Diamond, Douglas Gale, Martin Hellwig, David Pyle, Joe Stiglitz, Jean Tirole, Robert Townsend, and several of their co-authors. We were also inuenced by the ideas of Franklin Allen, Ernst

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Baltensperger, Sudipto Bhattacharya, Arnoud Boot, John Boyd, Pierre Andr e Chiappori, Mathias Dewatripont, Phil Dybvig, G erard Gennotte, Charles Goodhart, Gary Gorton, Ed Green, Stuart Greenbaum, Andr e Grimaud, Oliver Hart, Bengt Holmstr om, Jack Kareken, Nobu Kiyotaki, Hayne Leland, Carmen Matutes, Robert Merton, Loretta Mester, John Moore, Rafael Repullo, Tony Santomero, Elu Von Thadden, Anjan Thakor, Xavier Vives, Neil Wallace, David Webb, Oved Yosha, and Marie-Odile Yannelle. Some of them have been very helpful through their remarks and encouragement. We are also grateful to Franklin Allen, Arnoud Boot, Vittoria Cerasi, Gabriella Chiesa, Gerhard Clemenz, Hans Degryse, Antoine Faure-Grimaud, Denis Gromb, Loretta Mester, Bruno Parigi, Fran cois Salani e, Elu Von Thadden, and Jean Tirole, who carefully read preliminary versions of this book and helped us with criticism and advice. The material of this book has been repeatedly taught in Paris (ENSAE), Toulouse (Master March es et Interm ediaires Financiers), Barcelona (Universitat Pompeu Fabra), Philadelphia (Wharton School) and Wuhan University. We beneted a lot from the remarks of our students. The encouragement and intellectual support of our colleagues in Toulouse (especially Bruno Biais, Andr e Grimaud, Jean-Jacques Laont, Fran cois Salani e, and Jean Tirole) and Barcelona (Thierry Foucault and Jos e Marin) have also been very useful. Finally, we are extremely indebted to Claudine Moisan and Marie-Pierre Bo e, who competently typed the (too many) dierent versions of this book without ever complaining about the sometimes contradictory instructions of the two co-authors.

Outline of the Book

Because of the discouraging fact that banks are useless in the Arrow-Debreu world (see Section 1.2 for a formal proof), our rst objective (after providing a general introduction in Chapter 1) will be to understand why nancial intermediaries exist. In other words, what are the important features of reality that are overlooked in the Arrow-Debreu model of complete contingent markets? In Chapter 2, we explore the dierent theories of nancial intermediation: transaction costs, liquidity insurance, coalitions of borrowers, and delegated monitoring. The second important aspect that is neglected in the complete contingent market approach is the notion that banks provide costly services to the public (essentially management of loans and deposits), which makes them compete in a context of product differentiation. This is the basis of the Industrial Organization approach to banking, studied in Chapter 3. Chapter 4 is dedicated to optimal contracting between a lender and a borrower. In

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Chapter 5 we study the equilibrium of the credit market, with particular attention to the possibility of rationing at equilibrium, a phenomenon that has provoked important discussions among economists. Chapter 6 is concerned with the macroeconomic consequences of nancial imperfections. In Chapter 7 we study individual bank runs and systemic risk, and Chapter 8 is dedicated to the management of risks inside the banking rm. Finally, Chapter 9 is concerned with bank regulation and its economic justications.

Teaching the Book

According to our experience, the most convenient way to teach the material contained in this book is to split it into two nine-week courses. The rst of these courses covers the most accessible material of Chapters 1 through 5. The second course is more advanced and covers Chapters 6 through 9. At the end of most chapters we have provided a set of problems, together with their solutions. These problems not only will allow the students to test their understanding of the material contained in each chapter, but also will introduce students to some advanced material recently published in academic journals.

References
Bolton, P., and M. Dewatripont. 2005. Contract theory. Cambridge (Ma.) and London, England: MIT Press. Fudenberg, D., and J. Tirole. 1991. Game theory. Cambridge (Ma) and London, England: MIT Press. Garber, P., and S. Weisbrod. 1992. The economics of banking, liquidity and money. Lexington, Mass.: D. C. Heath. Gibbons, R. 1992. A primer on game theory. New York: Wheatsheaf. Greenbaum, S., and A. Thakor. 1995. Contemporary nancial intermediation. Fort Worth: Dryden Press. Huang, C. F., and D. Litzenberger. 1988. Foundations for nancial economics. Amsterdam: North-Holland. Ingersoll, J. E. 1987. Theory of nancial decision making. Savage, Md.: Rowman and Littleeld. Kreps, D. 1990. Game theory and economic modelling. Oxford: Clarendon Press.

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Laont, J.J., and D. Martimort. 2002. The theory of incentives. Princeton (N.J.): Princeton University Press. Mas Colell, A., M. Whinston, and J. Green. 1995. Microeconomic theory. Oxford: Oxford University Press. Mishkin, F. S. 1993. The economics of money, banking and nancial markets. New York: Harper Collins. Myerson, R. 1991. Game theory, analysis of conicts. Cambridge, Mass.: Harvard University Press. Salani e, B. 1996. The theory of contracts. Cambridge, Mass.: MIT Press. Tirole, J. 2006. Corporate nance. Princeton (N.J.): Princeton University Press.